Monday, March 2, 2009

Can the Fed Save the World?

No - at least not according to noted bear Hugh Hendry of Eclectica Asset Management. Speaking on CNBC yesterday, Hendry pointed out that "there is no precedent for quantitative easing succeeding."

Quantitative easing - printing money and using it to buy assets from banks - is the last weapon in the Fed's arsenal to stimulate the economy; with interest rates essentially at zero, simply printing money is all that's left to do. As Hendry notes, many investors assume this will work. These sanguine expectations more or less reflect a belief in the Friedman-Schwartz counterfactual: that the Fed could have prevented the Great Depression if only it had been sufficiently aggressive in flooding the system with liquidity to prevent the banking collapse of 1931-33. Ben Bernanke has certainly followed the Friedman script. In the last year and a half, the Fed has dramatically increased the size and scope of its balance sheet, furiously throwing money at the credit markets in an effort to thaw them out. Noting the explosion in the monetary base, many investors have concluded that the Fed's efforts at inducing inflation will be successful - perhaps too successful. Goldbugs have warned that hyperinflation is the real threat, even as deflation looms.

And yet, this fear seems misplaced. Indeed, as Paul Krugman explains, it is not at all clear that the Friedman-Schwartz thesis is correct. Despite the massive injections of liquidity into the financial sector, credit markets remain on life support and zombie banks continue to teeter along. We are finally getting an empirical test of Friedman's theory, and finding it seriously wanting. The problem today is that we have entered a liquidity trap. With the Fed funds rates at zero, the interest on any loan a bank made would be too low to justify the risk, especially considering the strain the precipitous drop in the real economy has put on would-be borrowers. As Krugman describes, at this point giving out a loan "just substitutes one zero-interest asset for another." Instead, banks simply hoard cash or invest in risk-free government bonds, as they seek to plug the gaping holes in their balance sheets. Consequently, despite a rapid increase in the monetary base, the monetary supply contracts; liquidity is "stuck" inside the banks as credit dries up.

While most accounts of a liquidity trap focus on the banks' incentives, Hendry posits that levels of household debt are so high that there may simply not be much demand for more debt at this point. Indeed, as the crisis has spilled over into the real economy and households themselves deleverage after several years of zero or negative savings, it is not at all clear that even fixing the banks will lead to enough lending to prevent a disastrous contraction of the money supply. To be sure, banks need to extend credit more responsibly than they did during the bubble years, and that implies a reduction. But at this point, the psychology of the crisis - the "animal spirits" of the economy - has shifted so suddenly and so dramatically, with confidence falling off a cliff since September, that reality has far outpaced policymakers' worst projections. Best-case scenarios keep getting revised downwards: growth in the second half of 2009; no, early 2010; no, 2011. It seems we are learning that depression prevention is theoretically feasible, but that it requires concerted action in monetary and fiscal policy - and on an international level too. Political considerations make this difficult to say the least. Europe is case in point. Unfortunately, we do not seem to live in Friedman's world. Extricating ourselves from disaster is actually quite difficult.

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